We’ve discussed this extensively over the past few weeks, but its now on the front page of the NYTimes:

“Many events in Washington, on Wall Street and elsewhere around the country have led to what has been called the most serious financial crisis since the 1930s. But decisions made at a brief meeting on April 28, 2004, explain why the problems could spin out of control. The agency’s failure to follow through on those decisions also explains why Washington regulators did not see what was coming.

On that bright spring afternoon, the five members of the Securities and Exchange Commission met in a basement hearing room to consider an urgent plea by the big investment banks.

They wanted an exemption for their brokerage units from an old regulation that limited the amount of debt they could take on. The exemption would unshackle billions of dollars held in reserve as a cushion against losses on their investments. Those funds could then flow up to the parent company, enabling it to invest in the fast-growing but opaque world of mortgage-backed securities; credit derivatives, a form of insurance for bond holders; and other exotic instruments.

The five investment banks led the charge, including Goldman Sachs, which was headed by Henry M. Paulson Jr. Two years later, he left to become Treasury secretary.

(emphasis added)

No wonder the bailout package is so poorly crafted: The same genius, Hank Paulson, that helped us to get into this, and has utterly failed to see this coming until it was all but on top of is, is trying to get us out. He is uniquely  unqualified for this task. How this guy hasn’t honorably fallen on his own sword yet is beyond me.

Here are a few money quotes from the article:

“We’ve said these are the big guys,” Mr. Goldschmid said, provoking nervous laughter, “but that means if anything goes wrong, it’s going to be an awfully big mess.”

“I’m very happy to support it,” said Commissioner Roel C. Campos, a former federal prosecutor and owner of a small radio broadcasting company from Houston, who then deadpanned: “And I keep my fingers crossed for the future.”

Now you know: Hoping and praying as a policy approach don’t really work all that well . . .

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Previously:
How SEC Regulatory Exemptions Helped Lead to Collapse (September 2008)
http://bigpicture.typepad.com/comments/2008/09/regulatory-exem.html

SEC: Brokerage Collapse Was Our Fault (September 2008)
http://bigpicture.typepad.com/comments/2008/09/sec-brokerage-c.html

Source:
Agency’s ’04 Rule Let Banks Pile Up New Debt, and Risk
STEPHEN LABATON
October 3, 2008
http://www.nytimes.com/2008/10/03/business/03sec.html

Multimedia:
The Day the SEC Changed the Game
http://www.nytimes.com/interactive/2008/09/28/business/20080928-SEC-multimedia/index.html

Category: Bailouts, Corporate Management, Credit, Derivatives, Taxes and Policy

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

31 Responses to “SEC Deregulation Let Banks Leverage Up”

  1. grumpyoldvet says:

    This an the CDS settlements for Lehman, WaMu due within the next 2/3 weeks and all the asshats on CNBS are jumping up and down about the merger between WF and Wachovia. Forget the looming disaster and talk happy talk. Kernan actually is getting a “woodie” talking about this merger.

    CNBS is as bad as Fox Business Network. Only decent people are Rick Cantelli & Steve Liesman.

  2. Dougist says:

    During this financial crisis I have been wandering the halls of academia, blog space and the business world and I’m shocked by our people’s lack of comprehension about what is going on in the economy. The misperceptions about the current banking crisis, its seriousness, the implications, and potential solutions defy understanding. There are times when I just shake my head.

    I have found that the groups of incomprehension fall into four camps and wrote about them here

  3. Bruce in Tennessee says:

    Paulson might have fallen on his sword if someone had led him to it.

  4. Winston Munn says:

    In truth, all these CEOs did was run to the SEC with the mantra chanted by all teenagers: It isn’t fair!

    The solution? Put adults in charge of the money….

  5. D. says:

    It’s just amazing how protection measures were taken away in the last decade. Most measures instituted during the Great Depression to protect us have been taken away with the excuse that times have changed:

    1. Glass-Steagall Act if 1933 which was designed to control speculation was repealed in 1999 (Just as high tech bubble was building up)
    2. Capital gains tax on home sale (up to 500K) repealed in 1997 (Just as home prices were gaining momentum)
    3. Exemption on bank reserves for brokerage units in 2004 (Just as real estate was hitting bubble territory)

    Every one of these changes was instituted to keep the game going when banks and brokerage firms were hitting a ceiling.

    All the stars were aligned, the fat cats made sure of that!

  6. Sarah P. says:

    Winston,
    You betcha! That’s a great idea! We need some mavericks who can do mavericky things with the system. Things so mavericky that one day we can sit around the dinner table and tell our children and our children’s children about how some blessed adults reformed the corruption in Washington and on Wall Street.

    Love ya, mean it,
    S.P.

  7. DaveM says:

    On the day that we hold our breath over an event likely to be viewed (much later)as a non-event, this was always the big issue. The consequences of leverage is easily made inaccessible to average newspaper readers. Then again, to anyone, anywhere, underwater on their mortgage, they can appreciate how hoping for a bottom in a growing crowd of afflicted “investors” in worse than unrealistic. So if people understand they caught the same disease as the brokers, when will they begin asking, why lever up our kids futures to help the big banks/brokers dig out when they are the ones who spread the contagion in the first place? Oh yea, the banks promised our eager (for campaign dollars) US Senators not to do it again. Fund all political campaigns from the general fund and make business money a thing of the past.

  8. How this guy hasn’t honorably fallen on his own sword yet is beyond me.

    Well, to do that one would need honor in the first place.. I think he’s waiting for his Presidential Medal of Freedom, which is the punishment meted out to Bush’s most incompetent staffers…

  9. Lars says:

    Quote: “No wonder the bailout package is so poorly crafted: The same genius, Hank Paulson, that helped us to get into this, and has utterly failed to see this coming until it was all but on top of is, is trying to get us out. He is uniquely unqualified for this task. How this guy hasn’t honorably fallen on his own sword yet is beyond me.”

    But Warren Buffett just said in the interview with Charlie Rose that Henry Paulson was the best man for the job at this time. Just defending his friend and his investments?

  10. Francois says:

    “I’m very happy to support it,” said Commissioner Roel C. Campos, who then deadpanned: “And I keep my fingers crossed for the future.”

    This decision was truly a faith-based initiative, wasn’t it?

    These scions of incompetence forgot the famous aphorism: “When it comes to Markets, hope rhymes with dope.”

    Guess it was too hard to “Just Say No”

  11. Arthur says:

    I’m with Lars on this one: Warren B said Paulson’s the man for the job, the man of the hour, thank goodness he’s there etc etc

    I tend to agree that Buffett seems sincere but Barry, are you saying the old man is out to lunch on this critical leadership question?

  12. Patrick Neid says:

    Say what you will, Paulson is a very shrewd guy at our expense. First he makes about 500 million at Goldman by being in the basements in question but his most brilliant move to date was then accepting the Treasury position.

    His response at the time was he wanted to be around in case there was a problem. Mighty big of you there Hank. He also knew he could walk away in less than two years as Bush left office. However that pails compared to his next smart move. By moving to the Treasury he was forced by regulations to liquidate his stock and options at Goldman–coincidentally near the high, but are you sitting down, he was absolved from any capital gains etc taxes because said regulation waives taxes because he was “forced” to sell to take a government job.

    I have a feeling this is why so many Goldman CEO’s etc pretend that it is time for some public service.

  13. Jay says:

    LOL…i saw it in the nytimes so it must be true. For anyone to try and pin blame, greed or corruption on one person or one party seems a little incomplete. Excessive deregulation is probably destructive as excessive regulation. Crooks don’t follow the rules. Oversight and transparency combined with free markets and common sense regulation is what is needed.

  14. dustin says:

    I first learned about this from your posting about the interview conducted by the New York Sun (R.I.P.). I’m glad to see this info is finally getting into the mainstream. I am stunned by how many people are reacting (I dare not say thinking) to the current crisis with mostly emotional responses based on ideology. “Socialism”… really? That’s the argument against the bail-out. The same one used against universal health care. Does this McCarthy-era crap still hold water with anyone under the age of 50 or objective economic thinkers? I realize pumping A LOT of money into the system will no doubt create problems and weaken the dollar for a long time. But come on…. let’s not revert to ridiculous slippery-slope scare tactics of how this will inevitably turn us into the soviet union (which is exactly what is implied by raising concerns about socialism). Without these ad hominem arguments, conservatives have a much tougher time convincing pragmatists that what is up is in fact down (government was the cause, so more government will make things worse). Let’s get over the hump, knowing full well the politics involved will make the process slower and less efficient than it could be, start planning ahead for the problems that will come up from the intervention, and start mending the way markets are regulated so that the country can expand for the next 30 years in a consistent and sustainable way. Bubbles may be inevitable, but huge cataclysmic bubbles need not be. Am I the only one that thinks this is possible? That there is a spectrum between socialism and laissez-faire, and the obvious explanation for why we are in this mess is we have not hit the right balance?

  15. D. says:

    Oversight and transparency combined with free markets and common sense regulation is what is needed
    ————————
    Obviously. So what’s your plan?

  16. VoiceFromTheWilderness says:

    Nobody ‘honorably falls on their sword’ anymore.

    In fact ‘honor’ if mentioned at all has become a purely manipulative trick — spin.

    The current leaders of our country have left all honor behind in their desperate bid for a power most of them already had. The remainder are acting out ugly vendettas against an entire society for having the termerity to catch them in the act of breaking the law 35 years ago. Their sycophantic supporters will lie cheat and steal, put lipstick on a pig, and call a club a diamond in order to preserve the power of those they adore, despite the fact that the adoration is not only not reciprocated but that indeed they are being made the scapegoats of these self same leaders policy actions.

  17. Greg says:

    BR, you have been right on with all of your analysis since I began reading your blog a couple years ago. I wanted to comment on the CRA article but usually don’t want to waste your time telling you that its right on. You’ve provided a centrist’s type of analysis without wacko (left or right I drank the coolaid crap) fairytales about some story never told. I’m glad you hit on this exemption as it was huge and I meant to comment on the CRA article regarding this. You know that the people complaining about your CRA article either don’t understand markets or are being deceptive. I work in the financial markets and regulation is a pain in my ass. But you can’t have 28 year olds betting billions of dollars of OPM with a heads they win tails the taxpayer loses framework.

    I have told my clients that two deregulatory actions had huge implications on this crisis: 1) Phil Gramm sneaking the total deregulation of the swaps market (remember him, whose wife worked at Enron and made out on the deregulation)into an omnibus spending bill in December 2000, and 2) this exemption for i-banks leverage. I think people can understand how the i-bank leverage exemption had a big impact, but no one commenting on this whole fiasco seems to understand how important the CDS market is in all of this. Everyone knows all the actors were complicit in this gigantic build up of debt(D’s and R’s), but these acts of deregulation were HUGE in why we are in such a perilous situation. I think you have read Mr. Practical’s musings – even looking at the chart that he showed often of Debt/GDP going higher than any time in our history (many others have pointed the same out), its hard for people to grasp how much worse it really is from the embedded debt in the 60 trillion market for CDS’s. We think its bad when MS or LEH are levered 40 to 1. They use derivatives and lever capital 100 to 1. Anyone ever heard of “economic interest” which is required for insurance contracts? CDS, no worries, don’t need it. Captial requirements to write CDS contracts, don’t worry, not necessary.

    What gets me is how quite a few people described this path we’re going down now – how it would be inevitable – 2 to 3 years ago. But they were called “reactionaries, crazy, etc.”. I guess you’ve been wrong all along Barry. Roubini too, guess he’s just some crazy. And people at Minyanville – bunch of wackos. Stetser, loonatic. Could go on and on. I’m just glad I positioned my clients for the storm to come last fall. Call me crazy.

    Love all your work. Btw, can’t wait to read the book – I think one of my collegues is researching a bit for you. Best of luck with it.

  18. D. says:

    One of the reasons why the US system is broken is because of its irrational fear of socialism. Americans want a social net but just don’t call it socialism!

    If America had embraced a little socialist rhetoric maybe government wouldn’t have had to lie as much. Most of America’s socialist policies have come through the back door, creating one of the most dysfunctional system in the world. Let’s start with healthcare. Did you know that US healthcare costs more than 5000$ per capita and its ranking falls well below that of most socialist countries. In the best socialist systems, the cost per capita is less than 3500$ per capita!

    I dont’t know if there is a fix for the ailing US system. History tells us that only a shock would change things.

  19. yernamehere says:

    Pretty pitiful stuff.

    As an engineering/science guy, I am skeptical of the “theoretical” foundations of biz and finance. I have seen a couple of quotes lately (sorry I don’t have references): “Finance is not a field that lends itself to innovation”, and “All financial innovation can be boiled down to more leverage”. If the execs had gone into these “innovative CDS, CMO, products” with this type of premise, we would not be in this situation.

  20. john says:

    “And I keep my fingers crossed for the future”? Wow. Just wow.

    I’m almost speechless.

  21. Devoish says:

    The third page of the article has a limk to the audio recording of the descision in question. It is astonishing the high degree of faith put in size and sytem. And how that faith deferred regulatory oversight.

  22. D. says:

    “Finance is not a field that lends itself to innovation”, and “All financial innovation can be boiled down to more leverage”.
    ————————–

    Our system has not changed over the last few centuries. Anyone saying the opposite is toying with us. It’s based on a fractional reserve system and confidence.

    Historically, all bubbles have involed debt repackaging.

    The “innovations” of the last 2 decades have been:

    - The types of repackaging
    - Reduced reserves

  23. Doug_S says:

    Changing the required capital ratio is not deregulation; it is lax regulation.

    When government sets up meat inspection the ordinary consumer is no longer concerned with the reputation of suppliers. How many people know the brand of the beef they buy? If government suddenly cut back the budget for meat inspection people would still rely on the USDA sticker. If governent announced that it would no longer inspect meat, you would see sales of kosher and like privately inspected products skyrocket.

    So govt said that they were regulating the capital ratio of the Street firms and then regulated it too low. The public relied on the govt as being a good regulator.

  24. Greg says:

    D. I realize this is lax regulation. Lax regulation forced by rebuplicans who controlled congress in 2004 and forced the SEC to do this. Phil Gramm’s sneaking in of the total deregulation of the swaps market was deregulation. Again, complicity all around, but it was the republicans zealous pursuit of “all deregulation is good” that put us over the edge.

  25. TDL says:

    D,
    It is a socialist system that supports fractional reserve banks, but your comments suggest that you would prefer a socialist system.
    On an other note: we’re we supposed to expect a banker turned politician to have honor? Hell, are we supposed to expect any politician to have honor.

    Regards,
    TDL

  26. OhNoNotAgain says:

    “Excessive deregulation is probably destructive as excessive regulation.”

    Not even close, my friends (a little Johnny there for ya’). When is the last time the US experienced a severe and sharp recession or depression due to excessive regulation or extremely rigid regulation enforcement ? How many times have we experienced the same due to excessive deregulation or lack of regulation enforcement ? There’s your answer.

  27. OhNoNotAgain says:

    “The govt said that they were regulating the capital ratio of the Street firms and then regulated it too low. The public relied on the govt as being a good regulator.”

    That is the story of the Bush administration. They’ve kept all of the enforcement agencies, but simply de-fanged them all by under-funding them or filling them with industry cronies. It’s extremely dangerous and insidious. The stupid assholes didn’t even have enough guts to actually put forth legislation to remove or disband such agencies because they knew the voters would have a fit. They’ve essentially undermined whatever little trust people still had in our government to actually do the right thing.

  28. Truth08 says:

    I was reading an article in favor of the bailout wondering how these Congressmen “who are not sophisticated enough to understand this crisis” should listen to the “experts” like Paulson on how to fix the crisis. Paulson helped cause this crisis! And we should listen to this guy? Give me a break
    The Truth Shall Set You Free – The Blame Game

  29. flory says:

    How this guy hasn’t honorably fallen on his own sword yet is beyond me.

    Can you think of one senior member of the Bush administration that has fallen on his sword? I can’t.
    The Bush Administration is never wrong. Events just don’t cooperate well with their ideology.
    For them, hope is a plan.

  30. Susan (Switzerland) says:

    thanks for that – one more fact which proves that Wall Street is all but corrupt and after nothing but personal gains. Apalling. And they want to fix that kind of unethical behavior with $700bn taxpayer money. Unbelievable. How twisted can you get? I find this truly sickening.

  31. DonkeyKong says:

    Smoke meet Gun, thanks Barry